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Safe Money Places • • • • •
Certificates of Deposit Fixed Annuities Money Market Account Savings Account Savings Bonds
Backyard, Mattresses, & Other Safe Money Places
One definition of safe money is money you cannot afford to lose. A safe money place is the opposite of a risk money place where principal can be lost due to circumstances beyond your control. We define a safe money place as one where your principal is protected from loss as long as you follow the initial guidelines, and if you do decide to take your money and leave, you know pretty much what leaving early will cost. A risk money place is one where if you decide to take your money, you don’t know what you will get back. It could be more than you put in – risk money places offer the potential for much higher returns than safe money places – but it could also be less than you started with or even zero. This summary describes and compares various safe money places. And to do that we must address one key question...
How Safe Is Safe?
We say a safe money place is a place where it is highly unlikely to lose principal. Notice we did not say impossible to lose, because in this world nothing is truly impossible. The risk of loss might be on a par with calling “heads”
Only Lose If You Choose Example: A certificate of deposit may charge a penalty equal to six months interest if the CD is cashed in before it matures. If money is taken out of the CD in the first six months that penalty will dip into the original principal and you will get back less than you put it. How do you avoid getting back less than you put in? Keep the CD for at least six months. A certificate of deposit is a safe money place because principal is protected as long as you follow the agreed upon rules. on a two-headed coin, and the only way you could lose is if the coin landed on its edge. The following places are for your “can’t afford to lose dollars.” We will summarize how each place works. Also, we tell you about the good and the bad for each safe money place. The yield section talks about past and current yields; the tax advantages section describes any special income tax treatment; the discussion in the safety of principal section addresses the “how safe is safe” question, and the liquidity & penalties section explains the cost of “choosing to lose.” Please Note: In this brochure, “liquidity” means “under normal circumstances.”
A bank can put a hold on withdrawals from a savings account balance (because a savings account is not a demand account like checking), and an insurance company may have the ability to stall in releasing cash from an annuity. However, it would take extreme financial conditions for either of these events to happen.
Why Aren’t Treasury Bonds Listed?
U.S. Treasury Bonds and Bills are direct government obligations, and if you hold them to maturity, you will get the stated value. What do you get back if you need to sell the bonds before maturity? There is no way of knowing, and this is why they are not included as a safe money place.
Red, White, & Blue – Savings Bonds Savings Bonds are issued by the U.S. Treasury. The bonds earn interest monthly. The interest is compounded twice a year. Savings Bond interest is exempt from all state and local income taxes. Series I Bonds are purchased for full face value; Series EE Savings Bonds are purchased at half of face value for an investment as little as $25. Yield The Treasury Department announces new rates each May and November for Savings Bonds. Series EE bonds issued on or after 1 May, 2005 lock-in and earn a fixed rate of interest for the 30-year life of the bonds determined at time of purchase. The rate is linked to rates on 10-year Treasury Notes. Series I Bonds combine a minimum rate with an index-linked component. The fixed minimum rate remains the same for the life of the bond, while the index-linked side is adjusted every six months to track the inflation rate as computed using the Consumer Price Index.
Series EE Savings Bonds offer a minimum guaranteed return, ensuring principal will
at least double after 20 years. This works out to an effective annual rate of 3.53%. In the past, people could exchange Series EE Savings Bonds for Series HH Savings Bonds starting 12 months from the EE Bonds’ issue date. This allowed consumers to continue deferring federal income taxes on the Series EE Bonds’ interest earnings for up to an additional 20 years. But this option went away after August 2004, when HH bonds were discontinued.
Tax Advantages Interest compounding within a Series I Bond or Series EE Savings Bond grows taxdeferred until it is redeemed or until final maturity is reached in 30 years, whichever comes first. Tax deferred does not mean tax free, as interest is taxed when withdrawn. If Series I Bond or EE Savings Bond interest is used to pay for college tuition and fees, and household income meets the IRS guidelines, the bond interest is excluded from federal income taxation (the education tax exclusion is described in 26 U.S.C. 135). Liquidity & Penalties The money placed in savings bonds cannot be withdrawn for 1 year. If redeemed within 5 years after purchase, the penalty for early withdrawal is equal to the last three months of earned interest. Safety of Principal You have to ask?
Savings Accounts A savings account is a bank instrument where money is extremely liquid and FDIC insured. Passbook Replacement – Money Market Accounts A bank money market account protects principal, is very liquid, and earns interest. Money market accounts may often be opened for as little as $100. Yield Yields are typically higher than those paid on bank savings accounts and lower than rates realized on certificates of deposit, but at times, money market rates have been higher than short-term CD rates. Tax Advantages None Liquidity & Penalties Extremely liquid; you can write checks on money markets (and the only penalty is the fee when you write too many checks during a month or quarter). Safety of Principal Bank money market accounts are FDIC insured and subject to their limits.
Mom, Apple Pie, & CDs A Certificate of Deposit (CD) is a bank savings account with a specified maturity. Maturities can be for any term length, but most range from three months to five years.
Yield Over the last twenty years the average interest paid on Certificates of Deposit has ranged from less than 1% to over 7%, and these yields may swing violently between one period and the next. As an example, the typical one year CD rate of 3.5% at the start of 2008 was down to 1% by the summer of 2009. 6 month CD Rates 91-11
Source: Federal Reserve Board
Certificate of Deposit yields are usually higher than money market accounts and, based on our research, yields earned on 5-year CDs might well exceed average rates earned on Series EE Savings Bonds. Tax Advantages Interest is fully taxable, even when money is compounding inside the CD. Over the past thirty years, taking into account the ravages of inflation and the top marginal income tax rate, real CD returns after taxes and inflation have been negative over half of the time. Liquidity & Penalties CD penalties for early withdrawal can vary from one month to one year’s worth of interest. Safety of Principal Certificates of Deposit are FDIC insured and subject to their limits.
Brokered & Callable CDs Another type of CD is a “brokered” CD. These CDs may pay higher interest than the local bank, and they are covered by FDIC insurance limits. However, with some brokered CDs, if you surrender before maturity, you may get the market value of the CD, which could be more or less than you initially paid. In addition, some CDs are callable – meaning the bank can stop paying interest and send you back your money at their discretion –
and this usually happens when current rates have dropped lower than what your callable CD is paying. Depending upon how they are offered, a brokered CD could be viewed as a security and therefore is not discussed.
Fixed Annuities:
Fixed Rate Or Linked Rate The textbook definition of an annuity is “a periodic income for a specified length of time, for life, or for a combination of the two.” But… An annuity can provide a means of accumulating interest on a taxadvantaged basis. An annuity can provide an instrument that preserves and protects assets.
There are variable annuities and fixed annuities. When newspapers and magazines mention annuities it seems they usually are talking about variable annuities. In a variable annuity, income or account value is based on the value of the stocks or bonds backing the annuity assets, so the income and/or account values fluctuate. Unlike fixed annuities, the investment risk to principal in variable
annuities is borne by the annuity owner; so variable annuities are considered investment securities and would be a risk money place. Fixed annuities provide a guaranteed minimum growth rate and are considered savings instruments. All fixed annuities are issued by insurance companies and are not government or bank obligations. Yield Fixed annuities guarantee a minimum interest rate and the potential for additional interest. Fixed annuities have often offered higher interest rates than other safe money places, such as CDs. There are two basic methods used in crediting interest. Stated Rate Many fixed rate annuities declare a new interest rate each year, while others lock-in a rate from two to ten years. The minimum guaranteed interest rate would either be set at the time of the annuity’s purchase or could change from year to year. Linked Rate A fixed index annuity is an annuity that earns a minimum rate of interest and offers the potential for additional interest by being linked to the movement of an index. The interest within the annuity grows taxdeferred, and, somewhat similar to Series I Bonds, the interest received is linked to the performance of an external index.
People may purchase a fixed index annuity because they are attracted by the possibility of higher interest. An index annuity offers the potential to earn more interest than they might receive from bank instruments or fixed rate annuities, and because an index annuity is not an investment, both principal and credited interest are protected from stock market risk.
Tax Advantages Money remaining inside an annuity grows without being taxed until withdrawn. Unlike qualified retirement accounts where you must begin taking out money around age 70½, most annuity contracts permit the owner to enjoy the advantage of tax deferral until age 85, 90 or even later. Tax deferred does not mean tax free as, interest is taxed when withdrawn. Also, the Treasury charges a 10% penalty on interest, in addition to regular taxes, if withdrawals are made before age 59½. Liquidity & Penalties Fixed annuities offer a wide variety of term choices. The fixed annuity selected may have a penalty for early withdrawal ranging from as short as one year to as long as fifteen years, although most permit the withdrawal of at least the interest earned each year without penalty. The term and liquidity provisions
should match your liquidity needs. Safety of Principal Fixed annuities do not subject principal and credited interest to market risk. A fixed annuity is as safe as the insurance company issuing the annuity, and insurance companies have an exceptional record of safety. This topic is discussed in greater detail in the next section.
Comparisons Of Safe Money Places Yield Passbook savings accounts will usually offer the worst yield because of the liquidity
(the exceptions are some checking-linked savings accounts). If you have money in a savings account the bank knows you are not shopping for yield and your money is not going anywhere, so why should they pay you a competitive rate? Money market accounts often have low yields because they are so liquid. The
bank needs to invest the cash backing the money market in short-term, highly liquid instruments just in case you need your money and the shorter the maturity of the instrument typically the lower the rate. Series EE Savings Bond returns have a floor; you know you will get back at least
double your money if you hold the bonds for twenty years. The money grows tax-deferred. However, the interest rate paid on new bonds is locked-in for the life of the bond. If interest rates are higher in the future you could earn less than market interest yields for years.
Series I-Bonds are a newer type of Savings Bond with a fixed rate locked in for the life of the bond that is combined with an inflation-linked rate updated every six months to track the inflation rate. How
will Series I-Bonds perform? It depends on how well we battle inflation. If stable prices win, Series I-Bonds lose; if stable prices lose, Series I-Bonds win. Certificates of Deposit offer a variety of terms and ease of use. The yields are
taxable and usually you may earn a little more interest if you select a longer maturity. Fixed annuity yields differ because fixed annuities offer different ways of crediting interest. Many fixed rate annuities declare
a new interest rate every year, but you only know what the initial year rate will be. The insurance company will declare a new rate each year that could be higher or lower than the initial rate, but it will never be lower than the guaranteed minimum interest rate. You can often find fixed annuities with first year rates that are higher than one-year CD rates. You can also find
fixed annuities that guarantee the interest rate for a number of years that can be quite competitive with comparable term CDs. The fixed index annuity offers a fixed rate annuity alternative to concerns over rising interest rates by linking interest to changes in an external index. An index annuity benefits from increases calculated for the index over a period, but even if the index goes down you can never lose principal or previously credited interest. Index annuity interest does not include dividends.The highest index
annuity interest rate credited for one year was over 40%. In 2001, 2002, and 2009, the major stock market indices went down and index annuities did not lose a penny. Tax Advantages Savings Bonds and fixed annuities offer tax deferral. What this means is that interest earned inside the account is not taxed until withdrawn. What this means is that while all of the safe money places earn interest on principal (simple interest), and all earn interest on interest (compound interest), only savings bonds and annuities earn interest on the taxes that would have otherwise been paid (tax advantaged interest). Tax deferred does not mean tax free.
Taxes have to be paid on the interest when withdrawn or at death. *However, tax deferral still means more dollars. An annuity gives you tax control. You decide when to take the interest and pay the taxes - not the IRS. In addition to regular income taxes there is a 10% penalty on withdrawals from an annuity before age 59 1/2. The penalty
only applies to interest earned and doesn’t affect the principal, but withdrawals are taxed on an “interest out first” basis. The textbook definition of an annuity is “a periodic income for a specified length of time, for life, or for a combination of the two.” Consult your tax advisor for more information. Liquidity & Penalties The clear winner is the money market. You can liquidate a money market account as fast as you can write a check. Savings Accounts have about the same general liquidity.
Savings Bonds are typically liquid after the first year and have a penalty equal to the last 3 months of earned interest during the first five years. Certificates of Deposit are generally liquid with a penalty, usually equal to six to twelve month’s interest, if cashed in before maturity. Fixed Annuities have penalties for early surrender that vary in length and severity.
Every fixed annuity offers a free-look period after purchase which enables the purchaser to review the annuity and return it for a full refund if they are not satisfied. The length of the free-look period is stated in the policy. A key difference between a certificate of deposit penalty and a fixed annuity penalty is that in a CD you typically begin a new penalty period every time the interest rate is renewed. However, with a fixed annuity, when the original penalty period is over, the penalty usually goes away forever. You
do not have to cash in the annuity when the penalty period is over; you can keep the annuity going – and keep earning tax-deferred interest – but it’s your choice whether to keep it or cash the annuity in. The Cost Of Liquidity Say that your choices were a money market account offering a yield of 1% with access to your money at any time without penalty, or a five-year certificate of deposit offering a yield of 2% but with a 2% interest penalty if you cashed in before the five years were up (Let’s ignore interest compounding to keep this simple). What is the liquidity cost of buying the CD if you cashed it in the day after purchase?
The bank would impose the 2% penalty and give you back 98% of your original principal. But if you liquidated the money market account you would receive 100%. Clearly, the liquidity cost of the CD is 2%. What is the liquidity cost of buying the 5-year CD if you cashed it in at the end of 3 years? Your immediate answer would
probably once again be 2% , but that does not accurately reflect the true liquidity cost. The CD has earned 6% (2%+2%+2%). After subtracting the 2% penalty, the cash in your pocket is 4%. The money market account has earned 3% (1%+1%+1%) and since there isn’t a penalty, you’d get the full 3%. But wait a minute. Even after the penalty, the CD is giving you 1% more interest than the money market – 4% instead of 3%. In reality, it is the money market that has the liquidity cost. In fact, from this point forward the liquidity cost of the money market account gets bigger. Even though places such as CDs and fixed annuities have penalties for cashing them in early, one needs to consider and compare the yield that might be earned in a more liquid spot. A penalty is only a cost if it is incurred. Safety of Principal Nothing is safer than a Treasury issued or insured obligation. If you hold a U.S. government security until maturity you will get back the entire face value. If your certificate of deposit, savings account, or money market account is in an FDIC insured bank, your combined account values are fully protected up to insurance limits. So, the real question is:
How safe are the alternatives that are not FDIC insured or issued by the Treasury?
Independent rating agencies, such as A.M. Best, assign ratings to insurance companies based on their financial strength. In addition, each state, in which the insurance company does business, examines the books on a regular basis. Based on history, it is very unlikely you would ever lose. Can I Lose Money In A Safe Money Place? Absolutely, if you don’t follow the rules you agreed to going in you could lose money. Getting out of a certificate of deposit or savings bond or fixed annuity early could cause penalties that eat into your principal. This is why you need to consider your liquidity needs.
Summary Savings Bonds and fixed annuities offer the benefit of tax deferral; money market and saving accounts afford the highest liquidity. Fixed annuities and Series EE
Savings Bonds guarantee a minimum return. Based on past results, fixed index-linked and stated rate annuities have delivered very competitive yields. Of course, past results are not a guarantee of future returns. All of the safe money places would benefit from rising interest rates, but only indexlinked annuities may also benefit from a rising stock market index. And all of the safe money places should protect principal. So, which safe money place do you choose?
For short term needs – when you think you might need the cash within a year or so many believe money market accounts make the most sense. Money market account interest usually beats a savings account. If you are going to need all of your principal within five years then certificates of deposit or shorter term fixed rate annuities may often be a good choice.
What about Savings Bonds? With the surrender penalties and the way interest rates are determined, Savings Bonds probably would not be the best choice. What about a longer time horizon? If you do not think you will need to spend your principal for five years or more then fixed index-linked annuities are positioned to provide the highest potential yield of all the safe money places discussed. And both stated rate and index annuities also provide tax deferral and minimum guaranteed return features. The reality is you probably need more than one safe money place. A combination of money market accounts, CDs, and stated rate and index-linked annuities, should meet all of your safe money needs. Regardless of the safe money place it is important to read all of the associated disclosures, as well as the NAIC Guide to
Fixed Deferred Annuities with Appendix for Equity-Indexed Annuities if you are
considering an annuity.
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Safe Money Places® is a collection of consumer education materials developed and produced by SMP International, LLC, which is not affiliated with any government agency, insurance company, or bank. SMP International, LLC does not sell or endorse any financial product. Copying, duplicating, or distributing any material is not permitted without prior written consent from SMP International, LLC. This information is for educational purposes only, does not provide legal, tax, or investment advice, and is not intended to be a thorough discussion of the subject. Readers should consult their own advisor for their personal situation. Any laws or regulations cited have been edited and summarized for clarity’s sake. Information is from sources believed accurate but is not warranted. SMP International, LLC is not liable or responsible for any financial decision based upon the information contained herein. © 2011 All Rights Reserved Safe Money Places® is a registered trademark. Printed by SMP International, LLC Carmel, Indiana Website: www.safemoneyplaces.com